Policy

STERIS settles System 1 dispute with FDA; plans customer rebates

Updated 5:58 p.m. STERIS Corp. (NYSE: STE) has settled with the Food and Drug Administration, […]

Updated 5:58 p.m.

STERIS Corp. (NYSE: STE) has settled with the Food and Drug Administration, addressing the “violating device” status of the company’s System 1 liquid chemical sterilizer and fleshing out a transition plan that will enable U.S. customers–mostly hospitals and surgical centers–to trade in their System 1s for rebates.

The terms of the consent decree resolve a two-year dispute with the FDA, which said STERIS  had changed the System 1 so much since its 1988 launch that the regulator no longer considered it a device approved for sale.

A Dec. 3 FDA safety alert about System 1 cast a pall of financial uncertainty over the Mentor, Ohio, technology maker, whose reliance on supply, accessory and service sales for the sterilizer (it no longer sells the sterilizer itself) led it to suspend its earnings guidance early this year. STERIS shares rose 36 cents, or 1 percent, to $36.21 on the New York Stock Exchange Tuesday, reflecting the removal of the uncertainty.

The decree, which is subject to approval by the U.S. District Court for the Northern District of Ohio, prohibits STERIS from selling liquid chemical sterilization or disinfection products that don’t have FDA clearance, formalizes a transition plan for STERIS customers and describes other process and compliance issues, the company said in a release.

The settlement could cost STERIS up to $100 million in rebates to System 1 owners. And the company’s revenue is likely to rise, but its profitability is likely to fall, as customers transition to alternative sterilization systems, which now includes the STERIS System 1E–the company’s next-generation liquid chemical sterilizing processor that the FDA  cleared for market two weeks ago.

For STERIS, the settlement ends more than four months of work with the FDA to figure out how to transition customers from System 1 to alternatives. “STERIS continues to believe the System 1 processor is safe and compliant,” Walt Rosebrough, the company’s president and chief executive, told securities analysts during a Tuesday morning conference call. “After more than 300 million uses, there have been no adverse effects to any patient known to STERIS when System 1 was used as directed.

“However, we believe it is in the best interests of all our customers, our investors and the company to resolve the FDA System 1 issues through this agreement. We believe that our transition plan will allow health care providers the time, financial support and information necessary to make the best possible decisions as they transition away from System 1.

On April 5, the FDA cleared for market STERIS’ next-generation liquid chemical sterilizing system–the System 1E (pdf)–after reviewing the company’s marketing application for more than a year. STERIS hopes to deliver the first System 1Es by the quarter ending Sept. 30. “We are excited about that clearance and believe we have the most comprehensive offering in the market as customers look to transition from System 1,” Rosebrough said.

The biggest difference between the two sterilization systems is System 1E is restricted to use for sterilizing heat-sensitive devices–endoscopes made with materials or adhesives that degrade when heated–while System 1 can be used to sterilize both devices that are heat sensitive and those that aren’t, Rosebrough said. Practically, System 1E likely will be able to process between 70 percent and 80 percent of the devices that System 1 can, he said.

STERIS will continue to sell supplies, parts and service for System 1 during the transition period. The company will offer pro-rated cash or credit rebates for System 1s and their supplies.

“The financial implications of the rebate program will vary, depending on how customers respond to the program,” Rosebrough said. “We currently estimate the impact to be up to $100 million. We will record a liability in the first quarter of fiscal 2011 (the quarter ending June 30) based on our estimate as a one-time reduction of revenue and pre-tax operating income.”

Rosebrough declined to cite the financial details of the transition, which the company will disclose in its May 6 earnings report. However, STERIS already is seeing declines in System supplies, accessories and service, which typically account for 10 percent of the company’s revenue.

“For the month of March, unit volume for S-20 stera (the sterilizing chemical used by System 1) in the U.S. was down between 15 and 20 percent compared to the same period last year,” he said. “We anticipate year-over-year declines will continue in fiscal 2011 for System 1 consumables as customers transition to alternative products.”

Excluding the rebate program, STERIS expects the net effect of the company’s conversion to System 1E from System 1 “to have a positive impact on revenue and a dilutive effect on operating income,” Rosebrough said. Questioned by an analyst about why operating income would be diluted, Rosebrough said he expects transition costs, making two types of sterilant instead of one, and a higher manufacturing cost for System 1E to narrow profit margins for the devices.

One of the transition costs is working with customers to get certificates of use enabling them to continue using System 1 through the transition period, which the FDA has limited to 18 months, starting in December.

Rosebrough acknowledged his company likely lost share in the chemical sterilization market in the months since the FDA safety alert on System 1. “Since December, we have been largely silent in the  marketplace in terms of taking orders,” he said. “It’s surprising if we haven’t lost share.”

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